Court of Appeal Considers Directors’ Duties of Supervision and Management

By Joy Tan, Partner

Wong Partnershio LLP

The Singapore Court of Appeal recently issued two important decisions both dealing with the scope of duties and liabilities of auditors and directors where fraud has been perpetrated on a company. These two decisions, issued on the same day and covering similar issues, will clearly become important touchstones in future. In brief, the Court of Appeal decided in both cases that:

• in carrying out a statutory audit, auditors have a duty to be alert to fraud and must assiduously investigate any suspicious matters; and

• the quantum of liability imposed on auditors should be reduced by 50% as the company's directors and management should have been able to catch the fraud but failed to do so due to negligence.

The two cases, JSI Shipping (S) Pte Ltd v Teofoongwonglcloong (a firm) and PlanAssure PAC v Gaelic Inns Pte Ltd, are examined in this article, which considers in particular their significance and implications for directors.

Facts of JSI Shipping (S) Pte Ltd v Teofoongwonglcloong (a firm)

The defendant was an accounting firm that provided audit services to the plaintiff during the financial years (“FY”) 1999, 2000 and 2001. The plaintiff was the Singapore subsidiary of an American freight-forwarding company. It had two directors. One was based in Singapore, while the other resided in the United States and was also the head of the plaintiff’s ultimate holding company.

The Singapore-based director had overall control and responsibility of the plaintiff’s day-to-day operations in Singapore and reported to the US-based director on operational and business issues. It subsequently transpired that the Singapore-based director was engaged in a scheme to siphon off the plaintiff’s profits for his own benefit. His activities were not discovered by the defendant, and they only came to light after one of the staff “blew the whistle” on him to the US-based director.

The plaintiff eventually sued the defendant for negligence in carrying out its audit duties. It alleged that the defendant had failed to pick up the fraud of the Singapore-based director in three principal areas:

• failure to verify the Singaporebased director's entitlement to remuneration;

• failure to report abuses by the Singapore-based director of his cheque signing limit; and

• failure to properly verify the renovation expenses of the plaintiff's warehouse in Singapore and of its Hong Kong subsidiary.

Facts of PlanAssure PAC v Gaelic Inns Pte Ltd

The plaintiff was a company that ran a pub. Its finance manager had misappropriated company funds through teeming and lading. This process essentially involved delaying the banking of cash received on the day of sales in order to hide misappropriations. Hence, instead of banking the cash received from a particular day’s takings into the company’s bank account, the finance manager would use the cash for her own personal benefit. The cash used would be replaced subsequently with cash received from subsequent sales. The teeming and lading was carried out substantially over 2003 and 2004.

Sometime in February/March 2004, as part of its audit of the plaintiff for FY2003, the defendant audit firm obtained a copy of the plaintiff’s bank reconciliation statement as at 31 December 2003. This was provided for the purpose of carrying out the audit of bank balances. From the statement, the auditor noticed that the amount of cash deposits which had not been banked into the plaintiff’s bank account (“unlodged cash deposits”) stood at more than S$600,000. He then asked the group finance manager for the dates on which the cash deposits were cleared and lodged into the bank account. However, unsurprisingly, this information was not forthcoming. By May 2004, the amount misappropriated had increased to some S$1 million.

When the misappropriation was eventually discovered, the finance manager was charged and convicted. The plaintiff then commenced a suit against the auditor for negligence, asserting that he had been negligent in failing to spot the misappropriations and to warn management that the high levels of unlodged cash deposits indicated a risk of fraud. It asserted that if the warning had been made, management would have been alerted in good time to prevent further losses and to recover the misappropriated sums from the finance manager.

Overview of Decisions in Both Cases

On the specific facts of these two cases, the Court of Appeal held that the auditors had not done enough to verify the propriety of the companies’ finances given the red flags that were raised during the audit process. Specifically, in JSI Shipping (S) Pte Ltd v Teofoongwonglcloong (a firm), the Court found that the defendant had failed to obtain independent verification of the Singaporebased director’s entitlement to remuneration. In PlanAssure PAC v Gaelic Inns Pte Ltd, the Court found that the defendant had failed to rigorously investigate the possibility of fraud given the unusually large amount of the unlodged cash deposits.

For directors, however, the cases raise important issues as to their duties of management and supervision. This is because, in both cases, the quantum of liability was reduced, and by the significant proportion of 50% in both cases. In broad terms, the Court decided to reduce the auditors’ liabilities because it was of the view that the directors and management of the companies had themselves been negligent. However, the legal routes used to achieve this result differed:

• In JSI Shipping (S) Pte Ltd v Teofoongwonglcloong (a firm), the quantum of liability was reduced pursuant to section 391 of the Companies Act. This section allows a court to grant relief to auditors under the circumstances specified.

• In PlanAssure PAC v Gaelic Inns Pte Ltd, the Court found that the directors, executive and nonexecutive alike, had not looked at the company’s accounts. If they had reviewed the accounts, even cursorily, the large amounts of unlodged cash deposits would have been immediately obvious and would have alerted them that something was amiss. This amounted to contributory negligence by the plaintiff.

Decision in JSI Shipping (S) Pte Ltd v Teofoongwonglcloong

In JSI Shipping (S) Pte Ltd v Teofoongwonglcloong (a firm), the Court noted that the US-based director never even looked at the plaintiff’s audit reports. They referenced one incident whereby the Singapore-based director had sent the original sets of audit reports to the US-based director to be signed by him. In doing so, he stated that he had already signed the reports.

The Court noted that this had been done in order to lull the US-based director into a false sense of security by implicitly representing that everything was fine. Separately, the Court also noted that the US-based director had been happy to rely on the perceived good work of the Singapore-based director in building up the business of the company, trusting him wholly and implicitly.

The Court then relied on section 391 of the Companies Act to grant relief to the defendant. As noted above, this section empowers the court to relieve a person either wholly or partly from his liability for negligence if certain conditions are satisfied. These conditions are:

• he has acted honestly and reasonably; and

• having regard to all the circumstances of the case, he ought fairly to be excused for the negligence.

It was accepted that the defendant had acted honestly. As to whether his actions had been reasonable, the Court held that reasonableness for the purposes of section 391 encompassed wider considerations, and could include the conduct of the company's directors. Here, the Court characterised the US-director's conduct as a "general indifference, laxity in management and failure to properly carry out his fundamental obligation to oversee and monitor the [plaintiff-company]".

It should also be highlighted that this alleged indifference and laxity was also relied on by the Court to decide that the auditor's negligence had not caused certain losses. In making a claim for damages, the plaintiff had claimed that but for the defendant's negligence, it would have discovered the frauds relating to the split cheques and warehouse renovations. However, the Court noted that the US-based director had been content to leave everything to the Singaporebased director, and that even after he had been notified of the possible fraud, he took such a long time to react that the Singapore-based director had been able to abscond. Accordingly, the Court held that these omissions broke the chain of causation linking the defendant's negligence to the plaintiff's losses in these two respects.

Decision in PlanAssure PAC v Gaelic Inns Pte Ltd

In PlanAssure PAC v Gaelic Inns Pte Ltd, the Court relied on the concept of contributory negligence to reduce the quantum of damages for which the defendant was liable. It is important to note that the High Court had excused the non-executive directors of contributory negligence, but found the managing director negligent in failing to even look at the monthly bank reconciliation statements which he received. The Court of Appeal indicted all three of negligent behaviour.

In doing so, it did not rely on whether the directors received or even reviewed the bank reconciliation statements. It noted that as directors, it was incumbent on them to at least perform a minimal degree of oversight in relation to the plaintiff’s accounts and seek to be regularly apprised of its financial affairs. While they were not obliged to delve into minute irregularities in the accounts, they were obliged to broadly discern if any irregularities existed on their face. The Court also noted that even a cursory monitoring of the bank statements would have immediately revealed that something was seriously amiss in relation to the banking in of collections from customers.

The Court also found the company to have been contributorily negligent from the acts and omissions of the accounts and payroll manager. It noted that she had prepared the monthly bank reconciliation statements and had regarded the increasing amounts of unlodged cash deposits as suspicious but failed to do anything about it.

Additional Observations on Directors’ Duties

The following observations of the Court on the responsibility of directors and management should be highlighted:

• It clarified that non-executive directors are not exempted from the need to exercise a certain level of scrutiny of the companies on whose boards they sit.

• While directors cannot be made to bear personal responsibility in all cases for the accuracy and integrity of all of a company's financial statements, both executive and non-executive directors cannot nonetheless shy away from the fundamentals of putting in place prudent arrangements to oversee the preparation of such statements. In this respect, it should be noted that the Court held, in PlanAssure PAC v Gaelic Inns Pte Ltd, that the non-executive directors were not entitled to wholly rely on the finance manager to ensure that the accounts were in order, and that, in this regard, it was irrelevant that they lacked accounting expertise.

• The duties of auditors and directors to check on management are not wholly distinct and separate, the one beginning where the other ends. Instead, these duties are overlapping, and auditors and directors share a dual responsibility to ensure their discharge. Importantly, the Court noted that effective corporate governance requires both sets of professionals to assiduously discharge their responsibilities Significance and Implications for Directors Companies, directors, and management will wish to take particular note of the Court’s reduction in the quantum of the defendants’ liabilities. It is worthwhile noting that in both cases, liability was reduced by 50%. This was perhaps intended to send a signal that responsibility between auditors and directors for financial statements is shared equally between both parties.

More importantly, by characterizing the responsibilities of auditors and directors as overlapping, the decisions suggest that directors, executive and non-executive alike, cannot simply rely on auditors but must exercise a certain degree of supervision and oversight in reviewing the company’s accounts. Again, it is worthwhile pointing out that the Court seemed to view the frauds as being readily apparent, and would have leapt out at anyone making even a cursory examination of the accounts.

The implications for a failure by directors in this regard can be severe, not only for the company but for the directors themselves. In JSI Shipping (S) Pte Ltd v Teofoongwonglcloong (a firm), the Court noted that the defendant had not sought to rely on contributory negligence and characterised its defence in this regard as “sorely lacking”. It should be noted that, as a company can only act through its human agents, if contributory negligence is found, it can only have arisen from negligence by its agents. This can only be the irectors, managers, or employees.

This in turn gives rise to a risk that the director, manager, or employee may in turn be found liable to the company for this negligence.

In a case decided earlier in 2007, Nagase Singapore Pte Ltd v Ching Kai Huat & Ors, the High Court held that while a court would be reluctant to fault a director who had in good faith delegated his functions or powers to competent subordinates, this did not mean that the director could never himself be held negligent because the loss complained of resulted from the negligence of his subordinates whom he bona fide believed to be competent. Even if they had proved themselves to be competent, a director or senior manager must have in place a proper system of ensuring that his subordinates do not make serious mistakes and that such mistakes, if committed, are quickly spotted and rectified.

It is likely that the issue and extent of proper delegation and supervision will become an increasingly important issue for directors in the near future. These recent decisions suggest a trend by the courts to impose strict duties of supervision on management and directors (executive and non-executive). As a practical measure to avoid liability, and as a best practice, boards and companies should consider setting up rigorous systems of checks and review, and to adhere scrupulously to such systems on a continuing basis. Any such adherence should be documented in order to maintain a record of steps followed.